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Industry Survivor Sounds a Warning

December 01, 1996|CHARLES A. JAFFE | Charles A. Jaffe is personal finance columnist at the Boston Globe

Jack Bogle had a change of heart, not principles.

Now he is urging both individual investors and mutual fund companies to change their attitude.

In his first public address since receiving a heart transplant in February, the chairman and founder of the Vanguard Group--the world's second-largest mutual fund company--sounded a warning that should not be ignored.

Bogle, speaking in November at the Society of American Business Editors & Writers Conference on Personal Finance in Chicago, didn't break new ground, but he covered territory that most experts have not ventured into for at least two years, since Bogle's poor health took him off the rubber-chicken circuit.

He railed against an industry focused more on gathering assets than managing them, and against investors who let short-term thinking dominate lifetime financial decisions.

Rest assured that Bogle, author of the best-selling book "Bogle on Mutual Funds," is no saint. But investors' adhering to his views would be of significant benefit to Vanguard.

At the same time, owning low-cost mutual funds that stick to their knitting and provide reasonable returns--a broad description that is apt for Vanguard funds--is not such a bad thing.

Here are Bogle's key points and how they hit home:

* The fund industry is focusing on distribution; you shouldn't be.

Bogle has harped on this point for a while, starting back in 1951 in his senior thesis at Princeton, which he concluded by noting: "The principal function of investment companies is the management of their investment portfolios. Everything else is incidental."

The Vanguard founder proceeded to slam Fidelity Investments Chairman Ned Johnson for his statements early this year when he said, "It's better to be in the distribution business, given that you have access to everybody else's business."

That speaks well for the fund supermarket business, but not necessarily for investors. Fund networks enhance convenience, but also encourage short-term trading that essentially heightens the risks involved in buying a fund.

On one level, you are investing with a manager who is speculating on the market. On a second level, you are speculating on which managers are hot. Think of a football quarterback trying to throw the ball to a receiver on the run. Most have a better chance of hitting the target if they are standing in one place and taking aim, rather than running for their lives and trying to make a good throw.

Heightened distribution often translates into higher expenses. In the last 15 years, the annual expense ratio for an equity fund is up 50%, to 1.55% from 1.02%, even as fund assets have exploded and should have created efficiencies that lower costs.

Just as important, a fund with great distribution gets bigger--and that is not to say always better. Size sometimes makes it harder for a fund to achieve the kind of results that attracted investors in the first place.

"Shareholders are paying the piper, as it were, but are not getting a better tune," Bogle said.

The point is very clear: If someone--be it a fund company or an investment advisor--is more interested in getting your money than in helping you manage it, get nervous.

* Cost should be as big a factor as returns and risk.

"Over extended periods," Bogle said in his speech, "costs often make the difference between top-quintile returns and average returns."

When other factors are equal, costs separate a good fund from a bad one. Say two funds invest in virtually identical securities so that their pre-expense return is virtually identical. The higher-cost fund, however, takes a bigger mouthful from its own plate, leaving less growth for you.

To overcome this high-cost hurdle, some fund managers take on excessive risk.

Mutual funds must compare their performance with that of peers. Since they are not compelled to compare costs, you will have to do the math yourself. The average expense ratio for a general equity fund is about 1.55%; for bond funds, it's roughly 0.95%.

* Performance is a lousy way to pick a fund.

For years, experts have maintained that a fund that starts small, racks up good returns and then draws in a huge influx of money is no longer the same beast. Its performance as a dwarf may not be relevant to what it can do as a giant.

Bogle advocates dollar-weighted returns, essentially a measure that gauges a fund's performance based on its asset size. The idea is to determine the kind of return that most money in the fund has experienced, rather than reporting on performance that latecomers never received.

Bogle cited Seligman Communications & Information, the fund with the highest conventionally measured return in the industry--roughly 20% per share, per year--in the decade ended July 31. The big numbers drew a ton of money, but most of it has never seen the fat years; Bogle noted that the fund's dollar-weighted return during that 10-year period is minus 4%.

* Ads may obfuscate the truth, but proxies generally don't.

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